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Hong Kong Launches New Regulatory Framework for Crypto Exchanges

Hong Kong Framework for Crypto Exchanges

Hong Kong’s SFC (Securities and Futures Commission) announced a new regulatory framework for virtual asset trading platforms, commonly known as crypto exchanges.

In 2018, the SFC announced a conceptual framework for potentially regulating virtual asset trading platforms, which aimed to gain a better understanding of whether it is appropriate to regulate them under the SFC’s existing powers.

After an in-depth examination of the unique technical and operational features of these platforms, the SFC finally concluded that some could be regulated.

The new framework covers the key investor protection concerns, safe custody of assets, KYC and AML/CFT requirements, market manipulation, accounting and audit, risk management and conflicts of interest management.

It also offers guidance on hot vs cold wallet (limiting cold wallet holdings to 2% of client virtual assets), forks and airdrops.

The SFC will also make sure that platform operators can only provide services to professional investors, and then only to those who can demonstrate that they already have sufficient knowledge of investing in this area. Licensed platforms will be required to insure themselves against the risk of virtual assets being lost or stolen.

As the SFC only has the power to regulate platforms that trade virtual assets that are legally classified as “securities” or “futures contracts”, platform operators will ultimately be opting-in to the regulatory framework by deciding whether or not to offer such virtual assets.

The majority of the more familiar crypto assets, including bitcoin, offered by platform operators are not securities.

However, if a platform operator offers just one ‘security token’, it would fall within the SFC’s jurisdiction and require a licence for Type 1 (dealing in securities) and Type 7 (providing ATS).

The benefit to opting-in is that it would then be able to say to all its clients that it is a supervised business. Once licences are granted to those platforms which choose to opt-in, investors will then be able to distinguish easily between properly regulated platforms, and all the rest.

As of 6 November 2019, the SFC has started inviting licensing applications from platform operators which are committed to and are capable of complying with the SFC’s licensing criteria and continuing conduct requirements.

In its newly issued position paper, the SFC sets out the key licensing conditions under the new regulatory framework.

These conditions include obligations to only offer its services to professional investors, have stringent criteria for listing virtual assets on platforms, adopt an external market surveillance system to supplement its own internal policies and controls, and ensure adequate insurance to cover the risks of virtual asset custody.

The adoption of the new regulatory framework will enable the SFC to formulate its future regulatory strategy for virtual assets through close supervisory interactions with an evolving and dynamic industry.

The SFC simultaneously issued a statement warning investors about the risks associated with virtual asset futures contracts, which it says are largely unregulated, highly leveraged and subject to extreme price volatility.

The regulator highlights that virtual assets – even if traded on newly licensed platforms – will not be subject to the same authorisation, prospectus and disclosure standards that apply to traditional securities.

Further, the SFC will not be able to take action against market misconduct in relation to virtual assets that are not classified as securities or futures contracts.

Notwithstanding the inherent limitations of its approach, the SFC has decided it is “manifestly in the public interest to act now”, to enable investors to choose to participate in platforms which agree to be regulated and supervised.

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